Bank Stocks Vulnerable as Rate Outlook Heads Lower

By

Michael Kahn

January 6, 2016

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It was not long ago that pundits became bullish on financial stocks, and banks in particular, in anticipation of the Federal Reserve finally changing its zero interest rate policy. After all, if short-term rates moved higher, it was because the Fed thought the economy could handle it and that, in turn, would give long-term rates the excuse to finally move up, too. Investors expected that the Fed’s actions would result in a steepening yield curve, allowing banks to borrow low and lend much higher for fatter profits.

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Given that banks are once again underperforming the broader market, however, and the yield curve itself is actually flatter now than it was in November, it seems that the market has a different outlook. And that does not bode well for further interest rate increases.

Just two months ago, when investors were still expecting banks’ net interest margins to improve, the SPDR S&P Regional Banking exchange-traded fund (ticker:
KRE
) jumped to a 52-week high. The move fully erased the summertime market swoon. Big banks represented by the SPDR Bank ETF (
KBE
), while not quite as strong, scored technical breakouts above major moving averages and enjoyed a brief period of market leadership.

But by December, even before the Fed actually raised rates, conditions changed. Banks stocks were lagging again and the spread, or difference, between the yield on the 10-year Treasury note and the two-year Treasury note – called the 10-2 or 2-10 spread – shrunk to the extremely narrow levels seen in July 2012 and February 2015 (see Chart 1).

Chart 1

2-10 Yield Spread

John Kosar, director of research at Asbury Research, said, “This represents a major decision point for the 2s/10s curve, which often leads the direction of long-term U.S. interest rates.”

The market is expecting that the Fed will only raise rates twice in 2016, which Federal Reserve Vice Chairman Stanley Fischer thinks is too low. “The Fed’s own forecast in its ‘dot plot’ are for four rate hikes this year,” Fischer told CNBC this morning.

San Francisco Fed President John Williams said earlier this week that the Fed could raise interest rates as many as five times this year.

The problem with a flat yield curve is that it usually appears when the economy is heading toward recession. The details are outside the scope of this column, but it is safe to say that a flatter yield curve would be bad for bank lending. And since financial stocks make up about 16% of the Standard & Poor’s 500, weakness in that sector would create a serious drag on the stock market from a technical point of view.

I would like to close on a more positive note, with a chart of the benchmark KBW Bank index, known as the BKX index. A long-term picture shows that it has struggled for the past few years and has been lagging the market for much of that time (see Chart 2).

Chart 2

KBW Bank Index

It is now trading about 5% above a very strong and very critical support level defined by a price floor going back to 2013. That leaves some room for short-term weakness without causing a major breakdown.

I don’t want to think what might happen if that level fails to hold. But since technical analysis assumes support will hold unless proved otherwise, there is no need to panic -- yet.

Getting Technical Mailbag: Send your questions on technical analysis to us at online.editors@barrons.com. We’ll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.

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